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1. [11 pts total] Assume the U.S. economy is currently operating at an equilibrium below full employment. (a) [3 pts] Draw a correctly labeled graph of AD/AS, & show each of the following. (i) Long-run AS [The 3 pts would be for drawing (ii) Current equilibrium output & price level the AD/AS graph, drawing the
LRASSRAS2 SRAS1
LRAS, and showing equilibrium below full employment.] AD1
PL2 PL1
E2 E1
(b) [2 pts] Now assume a significant increase in the world price of oil, a major production input for the U.S. Show on your graph in part (a) how the increase in the oil price affects each of the following in the SR. (i) Short-run AS Decreases as shown above [1 pt for showing decr in SRAS] (ii) Real output & PL Real output decreases & PL increases as shown [1 point] (c) [2 points] Given your answer in part (b), explain what will happen to unemployment in the U.S. in the short run. Answer (c) As indicated by Y2 in the graph, unemployment will increase due to the decrease in output caused by the decrease in AS. [2 points]
Y2 YR Y* Real GDP
Yen Price of Dollar
(d) [3 pts] Assume that the U.S. trades with Japan. Draw a correctly labeled graph of the foreign exchange market for the U.S. dollar. Based on your indicated change in real output in part (b), show and explain how the supply of the U.S. dollar will be affected in the foreign exchange market. [3 pts for correct graph showing S2$ D$ S1$ decrease in supply, which results
in a decrease in import demand.]
Y110 Y100
E2
E1
Answer (d): The decrease in real U.S. output will cause job losses in the U.S. and decrease the dollars supplied for Japanese goods, that is, decrease import demand.
Quantity of Dollars
(e) [1 point] Given your answer in part (d), indicate what will happen to the value of the U.S. dollar relative to the Japanese yen. [1 pt for depreciation] Answer (e): Due to the decrease in supply of U.S. dollars [as shown above], it will take more yen to purchase a dollar, depreciating the yen and therefore appreciating the dollar.
2. [8 total points] Interest rates are important in explaining economic activity. (a) [3 pts] Using a correctly labeled graph of the money market, show how an increase in the income level will affect the nominal interest rate in the short run.
Nominal Interest Rate
DM1DM2 MS
IR2
[3 points for drawing correctly labeled graph, showing an increase in Dm and the nominal interest rate rising.]
IR1
Money Market
Answer 2 (a): An increase in income will cause more consumption in the economy which will push up demand [to DM2 above] for money which will increase the nominal interest rate [to IR2].
2 (b) [3pts] Using a correctly labeled graph of the loanable funds market, show how a decision by households to increase saving for retirement will affect the real market interest rate in the short run. Real Interest Rate, (percent)
D
S1
S2
[3 points showing correctly labeled graph, showing increase in supply & real I.R. dropping.]
r1 r2
E1 E2
F1 F2
Quantity of Loanable Funds
Answer 2 (b): If householders save more the banks have more money to loan out [S2] which would decrease the real interest rate [to r2].
[Real I.R. + anticipated inflation = nominal I.R.]
+ 2%
6 %
Real Interest Rate
=
Inflation Premium
8%
Nominal Interest Rate
[Nominal I.R. – inflation rate = Real I.R.]
8%
2%
=
Inflation Premium
6%
Nominal Interest Rate
Real Interest Rate
2 (c) [2 pts] Suppose that the nominal interest rate has been 6% with no expected inflation. If inflation is now expected to be 2%, determine the value of each of the following.
(i) The new nominal interest rate (ii) The new real interest rate Answer 2(c)(i): The nominal interest rate is 8%. [6% real + 2% expected inflation premium] Answer 2(c)(ii): The new real interest rate would be 6%.
[8% new nominal interest rate – 2% anticipated inflation = 6% real I.R.] [*A point was also given here if the student says the real interest rate is 2% less than whatever they said the nominal was]
6%
Real I.Rates
3. [7pts] The unemployment rate is an important indicator of the health of the U.S. economy. (a) [1 pt] Assume that with the economy at full employment, the government implements an expansionary fiscal policy. How does the actual unemployment rate at the new short-run equilibrium compare with the natural rate of unemployment?
LRAS
AD1 AD2 PL2 PL1
SRAS
E2 E1
Answer 3. (a): Actual output [Yi] would exceed the natural output rate [Y*] at the new shor-run equilibrium [E2]. Therefore, the actual unemployment rate [4%] would be lower than the natural rate of unemployment [5%].
Y* Yi
5% 4% (b) [2 pts] Assume that a significant number of workers are involuntarily changed from full-time to part-time employment. Explain how this will affect the number of people who are officially classified as unemployed. Answer 3. (b): The official unemployment rate would not change because part-time workers are also counted as fully employed.
3 (c) [4 pts] Assume that the government reduces the level of unemployment compensation.
(i) Explain how this affects the natural rate of unemployment. (ii) Using a correctly labeled graph, show how this affects the long-run Phillips curve.
PL
LRPC2 LRPC1
[4 points given for saying the a.) natural rate will fall, b.) People have more incentive to look for work, c.) graph of LRPC, and d.) leftward shift of the LRPC]
Y2 Y1
Unemployment
Answer 3(c): (i): The natural rate of unemployment would decrease to Y2 because of “more labor” in the work force. (ii): Lower payment for unemployment compensation will mean that workers have more incentive to work and go out and search for jobs more quickly. They remain unemployed for shorter periods of time and hence the natural rate of unemployment tends to be lower. The LRPC would shift to the left to Y2.
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